Don't Stretch for Performance

How can you beat the market? Play a different game.

It's been a blah year for investors; the major stock market indices -- and most investment funds -- are all bunched in the 0-6% range. That's far better than the awfulness of 2002 but very disappointing to the many investors who earned outsized returns in 2003.

With weak returns so widespread, there's a powerful temptation to stretch for performance as we approach the end of the year. This is particularly true for money managers -- who are evaluated and paid mostly based on full-year results -- and especially for ones that are trailing their benchmark.

Absurdly valued stocksWhere do I see evidence of investors stretching for performance? Let's start with the stock market, which I think is, in general, moderately overvalued -- but there are plenty of pockets of absurdity. I recently looked at a list of the most heavily traded stocks, and all sorts of nonsense jumped out at me: Travelzoo(NASDAQ:TZOO), having risen in the past year from $5 to above $90 and valued at 344 times trailing earnings, is the most extreme example, but let's not forget the Travelzoo of six months ago, Taser(NASDAQ:TASR) (which has fallen only 27% from its all-time high -- there's a lot more to go), and some fine, yet highly overvalued companies such as Yahoo!(NASDAQ:YHOO), Research in Motion(NASDAQ:RIMM), Broadcom(NASDAQ:BRCM), and eBay(NASDAQ:eBay). The company with the lowest trailing P/E among these six stocks is Broadcom, at 60. (And I'm not even considering the impact that expensing options will have.) As a group, these stocks are sure to underperform significantly.

Credit spreadsStretching for performance isn't limited to equity markets -- in fact, it's happening to an even greater degree across credit markets, driven by hedge funds and institutions frantically seeking a little bit of extra performance in a yield-starved environment. The result, according to one of my friends who has decades of experience in this area, is that "all corporate spreads are insane -- it's shocking. Spreads have come in relentlessly over the past year." (The spread is the difference in the interest rate between the credit and the same-duration U.S. Treasury note. When investors are skittish, especially about defaults, spreads widen; when they're complacent, spreads shrink.)

How tight are credit spreads today? Here's one example: An index of speculative B-rated credits -- which are well below investment grade, with long-term five-year default rates exceeding 25% -- last week was yielding a mere 6.85%, only 368 basis points above Treasuries, the lowest spread ever. For comparison, only two years ago, for the week ending Oct. 10, 2002, the spread for the same B-rated index was 1088 basis points, an all-time high. (The next time someone tells you markets are efficient, ask them to explain how, in the span of only two years, credit spreads have gone from an all-time high to an all-time low. Yes, the economy has improved, but not by that much.)

I've seen this type of credit bubble before, and I know how it ends. Barring the mother of all economic booms, within a few years a substantial percentage of the struggling, low-quality companies that issued speculative bonds will start defaulting and the bondholders are going to suffer big losses. Mitigating this will be a few extra basis points of yield earned before the blow up. Does that sound like a good trade to you? There's only one word for it: insanity!

ConclusionIf I'm right that investors will be stretching for performance to an even greater degree at the end of this year, then the obvious strategy is to load up on the momentum stocks and junk bonds that they will likely be piling into, ride the wave until the end of the year, and then get out quickly, right? WRONG!!! Trying to predict where the herd is going is rank speculation -- the ultimate sucker's game.

The only way I know to beat the market consistently is to play a different game than the herd: Ignore the short-term noise and temptation to trade like a madman, and focus instead on buying stocks at a significant discount to their intrinsic value, conservatively estimated.

Whitney Tilson is a longtime guest columnist for The Motley Fool.He owned puts on the Nasdaq 100 tracking stock and the Semiconductor Holdrs Trust at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security.Mr. Tilson appreciates your feedback. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com. The Motley Fool is investors writing for investors.